Schumpeter Got Innovation Wrong, And Other Myth-Busting Ideas From A Nobel Prize Economist

Jerry Bowyer

1/24/2014 12:01:00 AM

Edmund, Ned, Phelps certainly did not need to writeMass Flourishing: How Grassroots Innovation Created Jobs, Challenge, and Change to make a name for himself. His work on labor market economics was both solid and itself innovative enough to earn him the Nobel Prize in Economics in 2006. But Phelps is concerned about his country. He sees a US which has gotten itself stuck in a low innovation rut, and to make matters worse, he sees a public discussion which itself is stuck in a rut of old ideas which looks to government planners, and the college professors as the bearers of the Promethean flame which will once again ignite our engine of new development.

I sat down across a Skype (a good example of modern innovation, clever, but not a true economic game changer) connection with Dr Phelps recently. If you are a regular reader of this column, you may notice some overlap between Dr. Phelps’ book and George Gilder’s recent Knowledge and Power, at least I did.

Or, you can read the first part of the transcript (edited for clarity) below:

Jerry Bowyer: “Hi, I’m Jerry Bowyer, thanks for joining us today. I’m honored to have as my guest Edmund Phelps; Professor Phelps is the 2006 Nobel laureate in economics; he is the author of numerous books of great influence; he is the Director of the Center on Capitalism and Society at Columbia University; and his latest book, which is absolutely fascinating — insights are jumping off every page, there’s hardly a page in this book that I don’t have one or two sentences underlined – this book is Mass Flourishing: How Grassroots Innovation Created Jobs, Challenge, and Change. Professor Phelps, thank you so much for joining us today.”

Prof. Phelps: “Thanks for interviewing me.”

Jerry: “Let’s start off with a topic that I think will be of interest to our Forbes readers: the great economist Joseph Schumpeter is rather a hero among my Forbes colleagues and is to me as well. But a significant part of this book is you taking issue with Schumpeter on some important points, especially regarding economic history and the nature of knowledge. Can you kind of fill us in on where Schumpeter gets it wrong?”

Phelps: “I’m glad you brought that up. One of my missions in the book has been to try to get economists to stop thinking of innovation – not all economists do it but a lot of them do – as a kind of routine, deterministic, commercial application of whatever advances scientists make. This is an idea that got going in the German Historical School before Schumpeter; they said outright that the discoveries of scientists and navigators propel the whole thing. And Schumpeter, for 30 or 40 years of his career beginning with his first great book, did not deny it; he simply added a new wrinkle. He said, “Yes, that’s true, but it does take entrepreneurs to make those commercial applications, and there’s a lot of effort and hustle and know-how in that.” I think between the lines he was saying that some countries have it and other countries don’t have it. You know, though, he was writing at a time that he didn’t have the whole 20th century under his belt. We understand a lot more about a lot of things now than Schumpeter could have understood in 1911. My position is that that’s all wrong. It is the business sector that generates most of the new ideas, and these new ideas might come from anybody working in a business, maybe while walking home from work, looking up and noticing something. Somerset Maugham wrote about that in a short story. I enjoyed quoting that.”

Jerry: “Oh, the tobacconist. The story about the tobacconist, right?”

Phelps: “Yes.”

Jerry: “I think there’s a film about that called The Verger, isn’t there?”

Phelps: “A film? I don’t know. It was a short story published twice, once under one name, “The Man Who Made His Mark,” and the second time in a collection of essays under the title The Verger.”

Jerry: “Yes. As I recall, he was a verger in a church and the vicar found out that he was illiterate and, since they had a high view of academic knowledge, they couldn’t have a verger who was illiterate so he fired him. Was that right? Am I recalling properly?”

Phelps: “You must have read some long version of the short story. I’ve only read the one in one of Somerset Maugham’s volumes. I guessed the church had run low on money or maybe somebody’s nephew got the job. They let him go abruptly. He was totally surprised.”

Jerry: “At least in the film version it’s illiteracy, which really fits so well with your thesis.”

·Phelps: “I didn’t see the film. We’ll have to put that in the second edition.”

Jerry: “He’s fired because he’s illiterate and he’s dejected, and he wants to smoke and he can’t find one, and so he decides to start a tobacco shop. And then he decides to expand into a chain of tobacco shops, and he goes to the banker and the banker wants him to read the contract and sign the paper and the tobacconist says, “I can’t read,” and the banker says, “You’re so successful, who knows what you would be if you learned how to learn?” and [the tobacconist] says, “I know what I’d be. I’d be the verger.”

Phelps: “That is really interesting. And it’s interesting from another point of view because for decades right up until fairly recently, economists have been shaking their heads and wondering how it is that so many of the country’s important innovators turned out to have less than the average education, or at least they didn’t have nearly the education of the CEOs running the big companies. They were relatively uneducated. And that reminds me that in Paul Johnson’s great book, called The Birth of the Modern, which precisely is about the economies that I open with in my book. He says that many of these important innovators from 1815 to 1830 like George Stevenson and some others couldn’t read or write, but they did extraordinarily novel, imaginative things.”

Jerry: “I forget the exact phrasing in your book but I think you say that these successful innovators, their knowledge is (I think) ‘specific’, ‘local’, and ‘kaleidoscopic’. Is that how you put it?”

Phelps: “Yes.”

Jerry: “And it’s not academic.”

Phelps: “A very important feature of this grassroots innovation was that it came from people who were in the front line and observing the nitty gritty on a daily basis, so they had ample chance to think about what could be done differently or what different things they could do.”

Jerry: “I think somewhere in the book you call them “scout ants” like ants that scout out ahead…”

Phelps: “I had forgotten that.”

Jerry: “Well, I have the advantage of having read it recently –“

Phelps: “It’s funny to think that you’re more of an expert on my book than I am.”

Jerry: “Well, I probably love it more than you because no writers really love their own books that much. They always think they could do better. This book is extraordinarily important. If it’s listened to, it could change the trajectory of the modern economy. And if it’s ignored, it could well fail to change the trajectory of the modern economy, or what’s become of the modern economy, and that would be a tragedy.”

Phelps: “That’s why I feel that even though I’m not always enjoying this promotional activity all the time, I really have an obligation to keep at it. But I just wanted to add one other thing… So, this business about a kind of lassitude or backwardness in the private sector comes up again in our economic policy discussions. A lot of people are saying, “Let’s look to the government to do a lot of innovating for us. It can draw on all the scientific personnel… not just the ones already working for the government … and it can hire others. They could do a great job of coming up with innovations.” But in many respects that’s a very false idea of what’s involved in innovation. You’ve got to have an instinct for what might work and be eagerly adopted by end users.”

Jerry: “And someone in government would not necessarily have that specific, local, kaleidoscopic knowledge.”

Phelps: “Yes, they’re too far from the front line. They don’t have any feel for what’s going on in industry. I mean, to look to the government to do our innovation for us is almost psychotic. It’s so out of touch with the world.”

Jerry: “Is it similarly psychotic to look to higher education or the social goal of 80, 90, or 100% of Americans participating in higher education? Is it similarly, let’s say, ‘delusional’ or ‘overly hopeful’ to think of that as a guaranteed solution to our innovation dearth?”

Phelps: “I think we’re putting a misplaced emphasis on human capital and expertise and technical prowess. There is so much enthusiasm about the STEM subjects. I’m not against education, of course, but it’s wrong to look to it as offering an automatic tremendous boost to innovation. Mathematics by itself never created an innovative idea; it’s just one of the many tools that we have for thinking about the execution of the idea and whether it would be workable and so forth. But on the other hand, I do think (and this gets ahead of the story) that there’s a strong case for more education in the humanities – the great books and especially the books of adventure and so forth. They might stir up the spirit of innovation.”

Jerry: “It seems to me that one of the central themes of your book is that the current famine of innovation that we’ve been in… I think what you say is essentially, “Apart from the brief feast in the late 90s, that famine has been in effect since the early 70s in the United States.””

Phelps: “That’s right.”

Jerry: “That the gap is not largely a gap in technical knowledge or a gap in higher education or a gap in government investment in infrastructure. It’s more a cultural gap than it is anything else.”

Phelps: “I think so. Now maybe I’m pushing that too hard but I’d rather push it too hard than push it too little. I think it’s a distinctive theme and it needs to be out there. I do think that there are problems on the institutional side; so much of the institutional structure we have was really created by society, and society hasn’t necessarily stuck with that structure. It could change the structure. We could have a complete overhaul of the financial system, so that we have more orientation toward financing innovators and less orientation toward financing people who want to own that house down the street. There’s such a fanaticism about homeownership.”

Jerry: “Which may actually decrease innovation because it ties people down geographically.”

Phelps: “Absolutely. That’s right.”

Jerry: “Boy, there’s two themes I want to hit at the same time but I’ve got Zeno’s paradox. There’s the mobility issue but I think maybe the more important theme, and one of the things I found most exciting about this book is the idea of pushing towards different financial arrangements – different structures of financial institutions – which could help kickstart innovation again. I’d love to hear you say more about that.”

Phelps: “I think it’s unfortunate that we’ve somehow drifted away from smaller banks that are rooted in their city or region, and that know intimately the businesses of the people they give loans to. It’s easy to pooh-pooh these little banks, and I know that nine times out of ten they’re just financing some inventory so let’s not glorify them too much, but sometimes I’m sure they helped a company get started. And now it seems we have giants — six or eight big banks in the United States (of course, there are huge banks in Europe too). I think that they’re so out of touch. I know that other kinds of financial entities could lend to would-be innovators, but that doesn’t mean that something wasn’t lost when we lost the small-town banks.”

Jerry: “You look at those large, money center banks and their balance sheets are absolutely stuffed with anti-innovative treasury bonds and anti-innovative mortgage bonds. What I’m hearing is that you want a George Bailey of small business.”

Phelps: “Yes. Unfortunately, as a friend of mine pointed out to me, George Bailey is not the model for us. He was heavily into mortgages. But maybe he’ll do for now, until we do a full investigation.”

Jerry: “The proximity of George Bailey. But what about the network of angel investors and venture capital people?”

Phelps: “Those roles are absolutely necessary but it seems to me that they’re not enough. I think we’re not serious about innovation; we don’t realize that it’s the lifeblood of an economy, and if we don’t have innovation that in itself is directly responsible for having fewer jobs than we would otherwise have. You know, if there are no innovators or no firms that have departments that are engaged in coming up with ideas for new products, new methods, new markets, et cetera – that’s fewer people needed in the workforce.”

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Mr. Bowyer is the author of "The Free Market Capitalists Survival Guide," published by HarperCollins, and a Forbes contributor.This article was originally published atForbes.com.